RM2-35.0
12-98
Hedging Milk with
BFP Futures and Options
David Anderson, Dean McCorkle, Robert B. Schwart, Jr. and Rodney Jones*
The 1996 farm bill changed the dairy industry forever. The security provided
by the support program is gone and the Federal Order reforms mandated in the
legislation may radically change the order system and dairy price levels. Since
1990, when price support levels were lowered substantially, prices have become
more volatile.
Milk prices fluctuate throughout the year because of seasonal demands, weather and supply fluctuations. Over longer time periods a variety of economic factors
drive milk price changes. Milk prices usually are lowest in late spring and early
summer and highest in late fall. This pattern follows the spring flush and the
increased demand for milk and dairy products during the school year and end of
year holiday season (Fig.1).
BFP (Basic Formula Price) milk futures and options can be used to hedge, or
lock in, milk prices in order to manage milk price fluctuations. For more general
information pertaining to hedging with futures and options, please refer to the following publications in this series: Selling Hedge with Futures (RM2-14.0), Buying
Hedge with Futures (RM2-15.0), Knowing and Managing Grain Basis (RM2- 3.0),
Introduction to Options (RM2-2.0), and Hedging with a Put Option (RM2-12.0).
Futures Contracts
A futures contract is a contract traded on a futures exchange for the delivery of
a specified commodity at a future point in time. The contract specifies acceptable
delivery methods and locations, and clearly defines the standards of the commodity such as weight, quantity, quality and form.
Figure 1.
5-Year Average Milk Price Seasonality
106.00%
% of 5-Year Average Price
nagement Educ
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k
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Uniform Blend Price — Dallas, TX
104.00%
102.00%
100.00%
98.00%
96.00%
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
5-Year Average = $13.77/cwt
*Assistant Research Scientist, Extension Economist–Risk Management, Professor and Extension Economist–
Dairy Marketing, The Texas A&M University System; Extension Agricultural Economist, Kansas State
University Agricultural Experiment Station and Cooperative Extension Service.
Depending on the exchange used, BFP futures
contracts are available for delivery of 50,000,
100,000 or 200,000 pounds of milk. Milk futures
contracts are traded on the Coffee, Sugar and
Cocoa Exchange, and on the Chicago Mercantile
Exchange. If a BFP contract is held open until
maturity, it is settled by the cash difference
between the contract price and the actual index
of basic formula price for milk at the time the
contract expires.
A hedger is someone taking a position in the
futures market that is equal and opposite to the
position he either has or expects to take in the
cash market. This position protects against
adverse price movements. That is in contrast to
a speculator, who is not hedging the price of his
own production but is hoping to profit on price
movement alone. The hedger could be a dairy
producer desiring to protect the price of milk or
the price of corn used to feed dairy cows, or the
hedger could be a cattle feeder desiring to protect a cattle price. A short futures position
means that a person sells a futures contract. A
long position means that a person buys a futures
contract. For example, a dairyman hedging his
milk would take a short position by selling the
BFP contract. A dairyman desiring to hedge feed
costs would take a long position by buying a
corn futures contract.
The milk producer considering hedging must
decide: 1) Do I lock in my milk selling price? If
so, for what month? 2) Do I lock in prices of
feed ingredients? If so, what commodity prices
do I lock in and for what month do I lock in
these prices? and 3) If I decide to lock in these
prices, at what levels do I lock them in?
During the planning process, the producer must
examine feed needs, expected feed prices,
expected milk prices, expected expenses, and
debt load, as well as desired returns to management, owner labor, and investment. In addition,
the producer must anticipate cash flow needs to
cover ongoing expenses and debt payments.
Basis
Basis is the difference between the local cash
price and the futures price at the time the milk
is sold or the feed grain purchased. Basis
accounts for transportation costs, quality differences, and local market conditions. Table 1
reveals the historical basis for the Federal Order
126 Uniform Blend milk price at Dallas compared to the BFP. Since the BFP is cash settled,
the basis is the local Uniform Blend price minus
the BFP. Grain basis tables for several locales
can be obtained from the Agricultural Extension
Service in both Texas and Kansas.
A producer will need to calculate the basis for
milk FOB his or her pay zone. Three important
aspects about calculating the basis must be kept
in mind:
1. Several years of historical price data should
be used to calculate the basis;
2. Basis data used should correspond to the
time the hedge is lifted or completed; and
3. Basis can be seasonal and cyclical.
In other words, it may tend to increase or
decrease over the production or marketing year
or show large changes across years. The BFP
basis, as the difference between the Uniform
Table 1. Federal order 126 basis at Dallas, 1992-1997.
1992
January
Feburary
March
April
May
June
July
August
September
October
November
December
$2.27
2.28
1.95
1.44
1.07
1.31
1.51
1.87
2.32
2.22
2.01
2.06
1993
$2.25
2.03
1.45
0.60
0.75
1.91
2.42
2.26
1.37
1.01
1.35
1.36
1994
$1.60
1.39
0.87
0.69
2.08
2.42
1.19
1.42
1.43
1.18
1.74
2.02
1995
$1.68
1.13
1.04
1.54
1.85
1.29
1.36
1.67
1.18
1.01
1.20
1.27
1996
$1.59
1.56
1.05
0.97
0.66
1.11
1.29
1.18
1.28
2.66
4.76
3.55
1997
Average
$1.56
0.96
1.17
2.17
2.62
2.15
1.87
0.96
0.39
1.38
1.74
1.51
‘92-’97
$1.83
1.56
1.26
1.23
1.51
1.70
1.61
1.56
1.33
1.58
2.13
1.96
Blend price and the BFP, captures changes in the
class utilization of milk in the Federal Order.
Recently, the Texas market has averaged about
50 percent Class I utilization annually. The Class
I differential at Dallas is $3.16 per hundredweight, which supports the positive historical
basis.
Cash Settlement
The term “cash settlement” means that at
expiration of the contract, the difference
between the futures contract price and the actual price on the expiration date can be settled by
a cash transaction rather than actual delivery of
the product. The BFP contract is settled by cash
so that milk does not have to be delivered to settle the contract terms.
Margin Call
When a producer opens an account and
begins trading, he or she is required to put a
certain percentage of the value of the contract
into a margin account to guarantee financial
security on the part of the contract holder. If the
futures market moves against the producer,
additional margin money will be required. If a
profit accrues (the futures market moves in
favor of the producer), money may be withdrawn from the margin account. When the
futures position is liquidated, the margin
account is used to settle the account. For example, a dairyman who is short a BFP futures contract will receive a margin call if the BFP contract price increases, because the dairyman
would have to buy the contract back to offset
the position, resulting in a loss on the futures
transaction.
A Hedging Example
To illustrate a hedge on an upcoming milk
sale, assume it is July 1 and the producer is
planning for December milk production. Feed
and hay prices for the production year are
locked in with forward contracts. The manager
wants to ensure that milk revenues will cover
expected cash costs during December.
The producer just returned from a co-op outlook meeting where the December BFP was predicted to be $11.04 (Table 2). Because the producer’s December basis averages +$1.96, he
realizes he faces a possible $13.00 milk check
for December milk if that prediction comes true.
Next, the producer finds that the BFP December
futures contract closed for the day at $12.54.
The producer needs a $13.89 per hundredweight milk price (Table 2) to cover cash costs in
December. Using either futures or options, the
producer decides he can hedge 1,400,000
pounds of his expected December production of
1,490,000 pounds. BFP contracts and options are
offered in 100,000-pound and 200,000-pound
units. A 50,000-pound mini-option is also
offered. Leaving 90,000 pounds unhedged allows
for possible production variation.
An at-the-money put option will cost $.35 per
hundredweight. However, the option will allow
him to escape margin calls and have the potential to gain back some premium if he chooses to
sell the option rather than let it expire. Using
options, the producer can lock in a milk price of
$14.11 for the hedged portion of his milk by
purchasing puts with a strike price of $12.50.
The producer realizes that hedging with futures
contracts has the potential to net more money if
the milk price falls.
Table 2 contains two examples of hedging
with BFP futures contracts. The bottom portions
of both the futures hedge and option hedge sections of Table 2 illustrate the returns above cash
costs with and without the associated hedges.
Example 1 illustrates a short hedge when prices
fall, while Example 2 illustrates a short hedge
when prices rise. In Example 1, the producer
sells a January BFP futures contract in July at
$12.54. When the producer lifts the hedge in
January, the futures price has fallen to $11.04,
resulting in a gain of $1.50 which increases the
net price received to $14.50 (1.50 + 1.96 basis
+ 11.04 cash BFP).
In Example 2, the producer sells the same
BFP futures contract for $12.54. When the
hedge is lifted in January, the futures price has
risen to $13.00 resulting in a loss of $0.46. But
the BFP cash price has also risen, settling at
$13.00. When adjusting the BFP cash price for
the loss in the futures market, the resulting net
price is $14.50, the same as when prices
declined in Example 1.
The hedging with BFP options examples in
Table 2 are the same as the hedging with BFP
futures examples. Example 3 illustrates the case
of decreasing prices, while Example 4 illustrates
rising prices. In Example 3, the producers buys
an at-the-money put option ($12.50 strike price)
for $0.35. When the hedge is lifted, the futures
price has fallen to $11.04. He executes the
option, sells futures at the $12.50 strike price,
and buys back at $11.04. After subtracting the
cost of the put premium ($.35) from the $1.46
gain in the futures position, the net gain on the
hedge is $1.11. When added to the BFP cash
price, the net price received is $14.11. Rather
than executing the option, he could have sold
the option back and achieved roughly the same
results. At expiration, a put option’s value is
composed entirely of its intrinsic value, which is
the strike price less the futures price. In this
case, the intrinsic value at expiration is $1.46.
In Example 4, prices have risen to $13.00
when the hedge is lifted. Since the futures price
is above the put option strike price ($12.50), the
put option expires without value. Therefore, the
producer simply lets the option expire and his
loss is equal to the cost of the option ($.35). The
loss results in a net price of $14.61 ($13.00 cash
BFP - $.35 option loss + $1.96 basis).
The producer could have chosen any strike
price above or below the $12.50 strike. For put
options the cost (premium) increases as the
strike price increases, and the cost is less for
lower strike price options. The opposite is true
for call options (the option to purchase a commodity at the specified strike price). The key to
hedging with options is to know your basis, production costs, price objective, and how much
risk you can bear.
Table 2. Hedging with the BFP futures and options contracts.
Assumptions
Producer’s total cash costs
Projected December BFP
Average December basis
Projected uniform blend cash price
December BFP contract on July 1
December put option strike price on July 1
Cost of December put option on July 1
Per cwt.
$13.89
$11.04
$1.96
$13.00
$12.54
$12.50
$0.35
Hedging with the BFP futures contract
BFP futures contract sold (July 1)
Cash settled BFP futures price (January 5)
Net on hedge
December BFP cash
Basis
Net price received*
Returns over cash costs w/hedge* (14.50-13.89)
Returns over cash costs without hedge
Example 1
$12.54
$11.04
$1.50
$11.04
$12.54
+$1.96
$14.50/cwt.
$0.61/cwt.
-$0.89/cwt.
Example 2
$12.54
$13.00
-$.46
$13.00
$12.54
+$1.96
$14.50
$0.61
$1.07
Example 3
$12.50
$0.35
$11.04
$1.11
$11.04
$12.15
+$1.96
$14.11/cwt.
$0.22/cwt.
-$0.89/cwt.
Example 4
$12.50
$0.35
$13.00
-$.35
$13.00
$12.65
+$1.96
$14.61
$0.72
$1.07
Hedging with BFP put option
Strike price (July 1)
Premium (July 1)
Cash settled BFP futures price (January 5)
Net on hedge
December BFP cash
Basis
Net price received*
Returns over cash costs w/hedge*
Returns over cash costs without hedge
*Excludes commissions costs.
Partial funding support has been provided by the Texas Wheat Producers Board, Texas Corn Producers Board,
and the Texas Farm Bureau.
Produced by Agricultural Communications, The Texas A&M University System
Educational programs of the Texas Agricultural Extension Service are open to all citizens without regard to race, color, sex, disability, religion, age or national origin.
Issued in furtherance of Cooperative Extension Work in Agriculture and Home Economics, Acts of Congress of May 8, 1914, as amended, and June 30, 1914, in
cooperation with the United States Department of Agriculture. Chester P. Fehlis, Deputy Director, Texas Agricultural Extension Service, The Texas A&M University
System.
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